Under IFRS 9, Financial Instruments, banks will have to estimate the present value of expected credit losses in a way that reflects not only past events but also current and prospective economic conditions. Clearly, complying with the 160-page standard will require advanced financial modeling skills. We’ll have much more to say about the modeling challenges in upcoming posts. For now, let’s consider the issues involved in classifying financial assets and liabilities.
The standard introduces a principles-based classification scheme that will require banks to look at financial instruments in a new way. Derivative assets are classified as “fair value through profit and loss” (FVTPL), but other financial assets have to be sorted according to their individual contractual cash flow characteristics and the business model under which they are held. Figure 1 summarizes the classification process for debt instruments. There are similar decisions to be made for equities.
The initial classification of financial liabilities is, if anything, more important because they cannot be reclassified. Figure 2 summarizes the simplest case.
That’s only the first step. Once all the bank’s financial assets have been classified they have to be sorted into stages reflecting their exposure to credit loss:
- Stage 1 assets are performing
- Stage 2 assets are underperforming (that is, there has been a significant increase in their credit risk since the time they were originally recognized)
- Stage 3 assets are non-performing and therefore impaired
These crucial determinations have direct consequences for the period over which expected credit losses are estimated and the way in which effective interest is calculated. Mistakes in staging can have a very substantial impact on the bank’s credit loss provisions.
In addition to the professional judgment that any principles-based regulation or accounting standard demands, preparing data for the measurement of expected credit losses requires creating and maintaining both business rules and data transformation rules that may be unique for each portfolio or product. A moderately complex organization might have to manage hundreds of rules and data pertaining to thousands of financial instruments. Banks will need systems that make it easy to update the rules (and debug the updates); track data lineage; and extract both the rules and the data for regulators and auditors.
IFRS 9 is effective for annual periods beginning on or after January 2018. That’s only about 18 months from now. It’s time to get ready.
IFRS 9 Figure 1
IFRS 9 Figure 2
FAQs
IFRS 9 divides all financial assets that are currently in the scope of IAS 39 into two classifications - those measured at amortised cost and those measured at fair value.
What are Stage 1 Stage 2 and Stage 3 assets? ›
Stage 1 which consists of loans overdue by up to 30 days, stage 2 where loans are overdue by 31-89 days, and stage 3 for loans overdue by more than 90 days. But on November 12, 2021, RBI issued circular on the prudent norms on income recognition, asset classification, among others.
What is staging in IFRS 9? ›
Definition. Stages and Staging of credit assets denotes the assignment / classification (at the reporting date) of all credit assets accounted under amortized cost in one of three available stages. The system resembles a Credit Rating System (with a limited number of rating categories).
What are the classification criteria for IFRS 9? ›
The classification decision for non-equity financial assets is dependent on two key criteria; The business model within which the asset is held (the business model test) and. The contractual cash flows of the asset (the Solely Payments of Principal and Interest 'SPPI' test).
How do you classify financial assets? ›
Financial assets can be categorized as either current or non-current assets on a company's balance sheet.
What are the three classification of financial assets? ›
In accordance with IAS 39, financial assets are to be classified in the following four categories: 1. financial assets at fair value through profit or loss; 2. held-to-maturity investments; 3. loans and receivables; 4.
What is the difference between Stage 1 and Stage 2 assets? ›
Stage 1 assets are performing. Stage 2 assets are underperforming (that is, there has been a significant increase in their credit risk since the time they were originally recognized) Stage 3 assets are non-performing and therefore impaired.
What is the difference between Level 1 and Level 2 assets? ›
Level 1 assets are the top classification based on their transparency and how reliably their fair market value can be calculated. Level 2 and 3 assets are less liquid and more difficult to quickly and correctly ascertain their fair value.
What is the difference between Level 2 and Level 3 assets? ›
Level 2 assets are the middle classification based on how reliably their fair market value can be calculated. Level 1 assets such as stocks and bonds are the easiest to value. Level 3 assets can only be valued based on internal models or "guesstimates." They have no observable market prices.
What are stage 1, 2, and 3 in IFRS 9? ›
Loans are sorted into stages, where Stage 1 comprises performing loans, Stage 2 underperforming loans that have seen a significant increase in credit risk and Stage 3 credit-impaired loans (see, for example, “Snapshot: Financial Instruments: Expected Credit Losses”, IASB, 2013).
If the credit risk has increased significantly (Stage 2) and if the loan is 'credit- impaired' (Stage 3), the standard requires allowances based on lifetime expected losses. The assessment of whether a loan has experienced a significant increase in credit risk varies by product and risk segment.
What is Stage 3 of IFRS 9? ›
Stage 3 – If the loan's credit risk increases to the point where it is considered credit-impaired, interest revenue is calculated based on the loan's amortised cost (that is, the gross carrying amount less the loss allowance).
What is IFRS 9 for dummies? ›
IFRS 9 describes requirements for subsequent measurement and accounting treatment for each category of financial instruments. It presents the rules for derecognition of financial instruments, with focus on financial assets.
How is IFRS 9 different from US GAAP classification? ›
The primary difference between the two systems is that GAAP is rules-based and IFRS is principles-based. This difference appears in specific details and interpretations. IFRS guidelines provide much less overall detail than GAAP.
What is a financial asset under IFRS? ›
According to the commonly cited definition from the International Financial Reporting Standards (IFRS), financial assets include: Cash. Equity instruments of an entity—for example a share certificate. A contractual right to receive a financial asset from another entity—known as a receivable.
How are assets valued under IFRS? ›
Under the principles of IFRS 13, Fair Value Measurement the fair value of an asset is the price that would be received to sell the asset in an orderly transaction between market participants.
What is the IFRS criteria for asset? ›
An entity should recognise an asset or liability if doing so provides: • relevant information; • a faithful representation; and • benefits that exceed costs. have a high level of measurement uncertainty.
How are assets measured under IFRS? ›
An entity shall measure the fair value of an asset or a liability using the assumptions that market participants would use when pricing the asset or liability, assuming that market participants act in their economic best interest.
